Who’s selling the theory of municipal bond laddering and why do some investors buy it?

It’s a question we found ourselves asking recently when we heard from an investor who has constructed a “high quality” 10-year ladder and was surprised by our steadfast belief in the wisdom of simply buying and holding long-term, high quality municipal bonds. This investor, wary of rising interest rates, feels that the ladder protects him over time if the value of long-term bonds erodes.

It’s an appealing theory, but if you strip away the myths underlying laddering and do some simple math, the shortcomings of this strategy are easily exposed.

Flawed assumption

A common assumption among some investors is that when you reinvest principal as bonds mature, you are keeping pace with “higher nominal rates.” Yet, if you have been employing a laddering strategy over any extended period of years, buying bonds every two years, as the aforementioned investor did, it’s worthwhile to review your trade confirmations. You will find that, almost invariably, you received either lower or similar yields on your successive 10-year bond purchases. (Prevailing interest rates in the U.S. have been declining, in a saw-toothed pattern, since 1982.)

Be that as it may, we don’t believe any fixed-income investment strategy should be predicated on one’s ability to forecast the future direction of interest rates. Throughout our 40 years in the business, we have never seen anyone accomplish this successfully for any reasonable period of time. As a matter of fact, as far back as we can remember, the majority of economists and pundits have consistently warned of higher interest rates, which have never materialized.

Laddering sacrifices tax-free income

The major flaw in the laddering strategy is that it necessitates sacrificing a substantial portion of available current tax-free income for the perceived advantage of reinvesting principal every two years, despite being subject to the vagaries of the market.

We recommend that investors maximize their income on every purchase, which produces significant additional income, and enables investors to reinvest this additional income on a current basis.

The 10-year laddering strategy calls for investing equal amounts of capital in municipal bonds maturing in two, four, six, eight and 10 years. A total investment of $1 million would call for purchasing $200,000 of bonds in each of these maturity categories. The theory is that $200,000 worth of bonds will mature every two years, allowing investors to reinvest in a new 10-year bond at the prevailing rate at that time.

For example, let’s look at today’s market and assume the bottom rung of the ladder is maturing and there is $200,000 available to invest.

According to Thompson Municipal Market Monitor, the average yield on a AAA 10-year bond is 2.93% today, while a 30-year bond of comparable quality yields 4.68%.

On a $200,000 investment, the 10-year bond, yielding 2.93%, produces $5,860.00 in annual income as opposed to $9,360.00 of annual income produced by the 30-year bond yielding 4.68%. This may not seem like much of a difference, but it actually represents 60% more tax-free income on this one purchase.

But wait! Thus far, we’ve only compared a 10-year bond with a 30-year bond. Remember, the laddered investor owns a blend of bonds maturing between two and 10 years. Taking this into account has a substantial impact on the analysis of the rates of return in the laddered vs. long- term portfolio.

Again, according to Thompson Data, if an investor were to build a $1 million laddered portfolio today, allocating $200,000 every two years for 10 years, the average return on this AAA- laddered portfolio would be 1.17%, producing annual income of $11,700. Investing in a variety of AAA bonds yielding 4.68% will pay $46,800 a year, a whopping $35,100 or 300% more income eligible for reinvestment on an annual basis. (We are omitting the significant compounding effect of this additional income over a 10-year period.)

Because we are only speaking of the income over and above that being earned by the laddered portfolio, the long-term bond investor has the ability to live on the same amount of interest as the laddered investor while adding $35,000 or more bonds to his portfolio on an annual basis.

Most tax-free bond investors find that the ability to have an additional $350,000 (35%) or more added to their principal every 10 years is a compelling reason to abandon any short-term ladder strategy and embrace the additional cash-flow afforded by long-term bonds.

Coincidentally, we were asked to make the same comparison by Bernard Condon for Forbes Magazine, Investment Guide, in June 2008. From the considerable response we’ve received, it’s apparent that this simple, common-sense approach has many adherents.

It is only fair to point out that the market value of longer-term bonds will be more volatile than short-term securities. Over the life of 30-year bonds, they will sometimes be worth more than you paid for them and sometimes less. To veteran municipal bond investors, this is immaterial since they are rarely forced to sell their securities.

Their main objective is to keep the “interest clock ticking” by buying quality bonds and maximizing their tax-free income on every purchase. The ability for the interest on your bonds to buy more bonds in an existing portfolio after you’ve retired is clearly a bonus.

The surprise, then, isn’t our adherence to a strategy of buying and holding quality, long-term municipal bonds. It’s why anyone would advocate and construct a ladder, which runs counter to why investors buy muni bonds in the first place; the tax-free income.

James A. Klotz is the President of FMSbonds, Inc. Email the Author03/23/2011